Managing retirement risks

When projecting your income in retirement, we take into account 4 major risks that retirees face in terms of protecting their assets:

Stock Market Risk – Proper diversification of your portfolio will help you tolerate stock market fluctuations and preserve your capital.

Longevity Risk – You have a 50% chance of exceeding your life expectancy.  Ensuring that you will have income to last throughout your lifetime is imperative.

Inflation Risk – The inflation rate can affect your ability to maintain your desired lifestyle.  Based on the historical average inflation rate of 4% per year, you would need an income of $109,556 in 20 years to buy the same basket of goods which you could buy today for $50,000.

Health Care Costs – It is very possible that you may have to spend a substantial portion of your retirement income on health care expenses.  While it is impossible to predict how much you may have to allocate for health care, it is important to be prepared for any eventuality.

Loss of Capital (or Stock Market Risk)

When you are working and accumulating retirement savings over a long period of time, stock market volatility is not a huge concern as long as your portfolio is properly diversified.  In fact, volatility will likely increase your return if you are investing a fixed dollar amount of a particular investment on a monthly basis.

One of the greatest risks in retirement income planning is having the stock market drop substantially just before or just after you retire, forcing withdrawals for income from your investment assets once they have declined in value.  You need to implement an investment and income strategy that will allow you to deal with extreme market volatility.

If you are unlucky enough to retire when the stock market is performing poorly and you need to generate income from your portfolio, then you could deplete your capital at an alarming rate.  Ultimately, this will reduce the chances of your portfolio being able to generate your required net spendable income throughout your remaining retirement years.

It is important to develop an investment strategy that deals with the volatility and short-term fluctuations in the market.

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Longevity Risk (Life Expectancy)

Life expectancy is one of the most misunderstood aspects of retirement income planning, yet it is one of the most important factors.  Most people assume that life expectancy is the same as lifespan. This is not correct.  Instead, life expectancy is a median number of years.  In other words, 50% of a particular age group will die before this number of years, and the other 50% will die after this period.

A couple who is 65 years of age has a life expectancy of approximately 26 years.  In this example, a couple aged 65 has a 30% chance that one of them will live beyond their 95th birthday.

For example, a male who is 65 years of age today has a life expectancy of 19 years; this means that he is expected to live until age 84. There is, however, a 50% chance that he will live longer than 19 years.  A female who is 65 years of age today is expected to live for another 21.5 years (age 86.5).   But, she has a 50% chance of living longer than 21.5 years, and a 41% chance that she will see her 90th birthday.

The result for a couple who are both age 65 becomes quite interesting. In this case, there is a 58% chance that 1 of the 2 will survive to see his or her 90th birthday!

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Inflation Risk

The inflation rate is usually measured by the year over year change in the Consumer Price Index (CPI). It measures how much a basket of commonly purchased goods and services increases in price over time.  There is a high probability that your retirement could last over 30 years. Therefore, it is important to understand how the inflation rate can affect your ability to maintain your desired lifestyle.  The following chart demonstrates that if you would like an income of $50,000 per year during retirement, you will need to spend more every year to maintain that standard of living.  For example, if the inflation rate was 4% (the historical long-term average), you would need an income of $109,556 in 20 years time to buy the same basket of goods which you could buy today for $50,000.

Inflation Rate 10 years 20 years 30 years
2% $60,950 $74,297 $90,568
3% $67,196  $90,306  $121,363
4% $74,012  $109,556  $162,170
5% $81,445  $132,665 $216,097

 

Even at today’s historically low inflation rate, you must plan for the negative consequences of inflation.

Is this enough income? This is a very difficult question. There is a general principle that states you will need 60% to 70% of your income immediately preceding retirement in order to maintain your standard of living during retirement. The rationale behind this rule of thumb is that in retirement, you are no longer saving, nor would you have employment-related expenses.

It goes without saying that this number will be different for everyone. It depends on what you intend to do with your life in retirement; this will drive your particular income requirements.

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Health Care Costs

As the baby boomer generation retires, our health care system will continue to be under increasing strain.  There may be substantial changes to the system, or you may lose the ability to live independently and need a caregiver.  Whatever the case, it is very possible that you may have to spend a substantial portion of your retirement income on health care costs.  Insurance policies can help protect you from the high costs of extended health care.  While it is very difficult to predict how much of your additional savings you should allocate to health care, it would be imprudent to ignore this potential problem.

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